Debt Crisis Back? European Bond Markets Crash, CDS Explode Amid France Budget Panic Contagion

It’s starting to smell awful sovereigny crisisy in Europe all over again.

In a vivid deja vu to the peak European debt crisis days of 2010 (and 2011… and 2012… and 2015), credit spreads, credit default swaps and the risk premium in euro-area government bonds exploded on Thursday to levels not seen in over a decade, following a rout sparked by concerns around France’s fiscal and political situation which in addition to local social chaos, is starting to spill over into other markets.

The spread between Italy and Germany’s two-year yields almost doubled to 55 basis points on Thursday, the biggest daily jump since 2020 on a closing basis.

The equivalent gap for France rose as much as 22 basis points, the most since 2012.

Meanwhile, the spread between 10Y French OATs and 10Y Bunds has soared to 1.41%, the highest going back to the 2012 European Sovereign debt crisis.

A measure of French bond risk reached another milestone this week as investors positioned for political upheaval next year and an ongoing deterioration in the country’s public finances. The widely watched spread between France and Germany’s 10-year yields jumped 14 basis points on Thursday to 141 basis points, already the widest since 2012.

French CDS has more than doubled in the past month on mounting fiscal viability fears. 

Today’s violent moves came as German bonds rallied sharply as investors rushed for the region’s “safest” asset (which is ironic for a country whose entire manufacturing sector has been gutted by China), while dumping everything else. Curiously, Treasury yields also surged during the European session, as locals dumped US paper alongside the periphery, although the selloff ended the moment Europe closed.

The nervousness suggests the selloff in French markets caused by the nation’s struggle to get a grip on runaway public finances is starting to sap risk appetite more broadly, as we first laid out two months ago in “France’s €107 Billion Deficit Shock: The Next Euro Debt Crisis?“

“France has been slowly but steadily breaking,” said Mike Riddell, lead manager of Fidelity International’s Strategic Bond Fund. “But today feels like the first day that broader financial markets have noticed.”

He’s right: 

• ITALY-GERMANY TWO-YEAR BOND YIELD SPREAD WIDENS MOST SINCE 2020
• GERMANY-FRANCE 10Y YIELD SPREAD CLOSES 14BPS WIDER AT 141BPS

There were also signs that markets are starting to price the toll from higher yields – which tighten financial conditions – on the economy. Traders slashed wagers on the extent of further interest-rate hikes from the European Central Bank, and swaps are no longer fully pricing three more quarter-point increases. As recently as Tuesday, they were betting on at least four more. 

“The price action is very unusual,” said Rohan Khanna, head of European rates strategy at Barclays. “We are reducing ECB rate hike expectations, yet the EGB complex, with the exception of Germany and the Netherlands, is selling off. It is reminiscent of periods when bond market fragmentation was a major concern, such as during the European sovereign debt crisis.”

In other words, it is reminiscent of when Europe was on the verge – or already in – a debt crisis. 

As Bloomberg notes, investors and strategists also said the moves suggested hedge funds have been forced to capitulate on positions as the market moved against them and losses piled up.

“One of the favorite hedge fund carry trades was to own short dated France versus swaps,” added Fidelity’s Riddell. “Some of these positions must have been reduced the past few weeks, but it feels like a capitulation.”